11 Things You Don’t Know About Raising Capital The First Time Around
Answer #2 to great questions I’ve been asked while teaching entrepreneurship to MBA students at AGSM @ UNSW Business School.
Question 2: What should I know before I begin raising capital?
Any founder will tell you that fundraising is an essential distraction. It takes you away from shipping product, building partnerships and hiring the best available talent. And there is no question that bootstrapping a startup is THE way to go but for at least 70% of founders the need for capital and strategic assistance to take a product to market is essential.
Raising capital is physically and emotionally intense.
It will take longer than you think and you will be told ‘No’ many more times than ‘Yes’ and until the deal is closed even a initial ‘Yes’ is usually ‘Maybe’ (at best). You will call into question why you’re putting yourself through this process and there will be times when walking away looks and feels like a very attractive option. This is part and parcel of entrepreneurship. It’s opt-in, remember that.
Although raising capital can take it’s toll the good news is that, like anything, you become better with practice. But like everything there are retrospective ‘if only I’d known’ insights that can make life a little easier.
So here are the 11 fundamentals I’ve learned based on my experience (read: from serious rookie mistakes to closing rounds and everything in between) at AirShr and other ventures, and supporting other founders in their financings.
1. Raising capital is about relationship development
When you ask people for their hard earned money to support your vision expect that you are walking into a 10-year, one-to-many relationship. Rarely does it take less than 10 years to grow a great company and by one-to-many I mean that there will be you and your team and a collection of investors who may or may not know each other in the beginning. As you move from one milestone to the next (and endure the inevitable one step forward, three steps back approach to achieving product/market fit) the management and investor teams become one and endure the journey together.
This relationship can only be based on trust, respect, candour, and regular, authentic communication. And each investor relationship begins with an introduction that signals an opportunity for a mutual exchange. And mutual doesn’t always mean equal, after all there is a power imbalance between investors who have resources and entrepreneurs who need them. In the context of mutual exchange it means that the entrepreneur may be able to access capital and strategic value. Likewise, the investor may have the opportunity to work with visionary entrepreneurs capable of putting a dent in the universe. Although entrepreneurs and investors are both busy people, these relationships only flourish when entrepreneurs invest effort in making regular contact with prospective or current investors to check-in and provide progress updates, share insights which will be interesting to them or even to wish them happy birthday.
LinkedIn is the platform I use to keep up to date of my investor, partnership and a host of other relationships. You should too. It’s power extends well beyond network and content and into relationship management (just look at the Relationship tab in any one of your first degree connections).
Developing and fostering relationships is a core capability for entrepreneurs. Get very good at it.
2. People invest in business models. Idea’s don’t cut it anymore.
Forget about walking into an investor meeting with a pitch deck that sells only a vision. Gone are the days where that’s enough. Today and in the foreseeable future demonstrating evidence that a business model is functioning well or has potential to flourish is a precondition for investment. Evidence equals traction and Ash Maurya is my go-to on this topic. He describes traction as a measure of how a business model delivers and captures monetisabe value from customers. And if you’re just starting out, traction is a reliable leading indicator of future business model growth.
In both cases, and regardless of whether you lead a direct (local cafe), multi-sided (like Facebook) or marketplace (like OneFlare) business model, traction is always based on a customer action or behaviour and the rate at which a business captures monetisabe value from its customers. Think of Facebook, they consistently report on size of their user base and monthly active users. Although there are a host of operational metrics that exist, these two measures provide all the evidence needed for Facebook to demonstrate traction and monetise the value of its users.
But beware of measures that do not contribute to capturing value (i.e. number of downloads, number of survey respondents or growth in team size). These are vanity metrics. They are always convenient measures and inevitably grow left to right. They do not demonstrate traction and can be identified a mile away.
And with all the hype about big cheques being written for great ideas in the last decade (and in some cases recently in the US), founders can be lulled into the belief that raising capital is simple and straight-forward. Unless you’re a serial entrepreneur or founding team with a seriously impressive track record, closing a large round is usually a hard-fought battle laced with trade offs and shifting timelines. This is the reality for 90% of founders which isn't often featured in popular startup media.
3. Investors live at all points of the sophistication spectrum
Most shareholder registers of early stage companies consist of parties who have a wide variety of investment experience. At one end of the spectrum there are those who are highly sophisticated which is to say they know the practical ins and outs and realties of early stage investing. These investors pride themselves on being pattern recognitionists, after all their experience has repeatedly exposed them to what works and what doesn’t in terms of identifying, backing and growing early stage ventures. Those who do this well typically provide a quick decision (one way or the other) on an investment and when the financing round is closed they will be the one’s saying: “My job now is to get out of the way and let you deliver. Call me whenever you need me”. In my experience the speed at which these investors make considered decisions is the leading indicator on how effective they will be as a member of the investor team.
At the other end of the spectrum are those who have limited experience investing in early stage companies. Generally they are enthusiastic and rely on their accountant, financial advisor or lawyer for guidance on their investments.
The degree of due diligence and relationship development required when trying to close a round can correlate to the level of investor sophistication. The higher the mix of investor sophistication, the longer it can take to bring everyone onto the same terms and close the round. Of course, in some cases the opposite it true. The point is to be aware of how different investors engage in a process. Typically this means closing a round takes longer than expected.
4. Recruit strategic investors (and avoid accepting only cash)
There are investors with cash to invest and there are investors with cash AND specific strategic knowledge to invest. Focus on recruiting the latter — strategic investors. These people bring industry, product or distribution expertise to the table or they posses a complementary expertise e.g. law or technology investment that you can lean on.
The term ‘recruit’ is used specifically in this context. Just like recruiting the best talent, it’s equally important to recruit the best investors for your company. Framing the exercise as recruiting (in contrast to just ‘finding’) helps hone in on investors or funds that are likely to be a better fit. LinkedIn is again the perfect environment for identifying and recruiting strategic investors (more on that in next week’s post).
In AirShr’s case we have a powerful team of strategic investors who are called on from time to time for their counsel.
The filter to understand how valuable a prospective strategic investor will become to your company (beyond their experience) is based on three practical factors:
- You won’t call on them super frequently but when you do, they will call you back within 24 hours — time is always of the essence.
- When you ask for assistance to make an introduction to a potential partner or customer, they action it within 24 hours.
- At every appropriate opportunity they evangelise your company and brand.
Just ask if they are OK with meeting these expectations. It demonstrates your desire to leverage every available asset at your disposal to deliver on the vision. Importantly, it also gives you a sense if prospective investors understand the importance and value of time, it’s always in short supply.
Seed rounds also attract friends and family investors. They often invest early on to provide encouragement and help progress your vision. This is common and expected. Providing they are fully aware of the risk of investing, they too can be a trusted sounding board as you become too close to your product or business model and need a fresh perspective.
5. Focus on domestic investment
Investors often prefer to be geographically co-located with the founders leading their portfolio companies. It’s obviously easier for them to provide support if they’re nearby. There are exceptions to every rule but this is the consistent feedback I’ve received from early stage founders who have been declined investment from overseas investors.
6. The ideal runway is 18 months
However accept 12 months worth of funding to achieve your essential milestones and product/market fit.
7. Your idea is only new and shiny to you
When you pitch your business model be prepared for investors to respond in one of two ways; 1) They get it and then apply their own mental model to your business or 2) They don’t get it and then apply their own mental model to your business. See where I’m going with this?
Experienced investors will rely on the countless number of startups they’ve encountered and draw parallels between this experience and your business model. In both cases, whether they accept your business model or not, listen carefully to their feedback. Even if you disagree with their insight or characterisation of your business model there’s a good chance others will come to same conclusion. Consider this (and all other) feedback as clues to investigate further.
Ignore them at your own risk.
8. Your pitch deck should be compelling and 10 slides (in this order)
- Solution (Your vision is in the future, sell it early)
- Problem (Present today’s experience/use-case being solving)
- Market Size / Opportunity (Is the opportunity big enough to pursue?)
- Product (Show product/service that embodies the solution)
- Traction / Timeline to Traction (Demonstrate tangible progress)
- Business Model (How value is captured from customers)
- Marketing & Distribution (How product/service will get to customers)
- Competition (Who is/will threaten the business model)
- Team (Who will deliver on the vision and are they qualified?)
- Competitive / Unfair Advantages (Why will the venture win?)
- Use font size 44 in the body of each slide
- Consider your potential exit options and be prepared to answer related questions but don’t add a slide on it. There are many milestones and alot of luck to experience before exiting becomes an real option
- Be clear on the investment required, how the funds will be applied and 3–5 key milestones to be achieved given the runway provided by the investment
9. The other half of a pitch deck is a term sheet
When it comes to engaging with prospective investors it’s important that a well-considered term sheet is available for distribution to interested parties. This document presents the terms underwhich incoming and existing investors will engage as owners of a company. These terms will be later incorporated into a shareholder agreement.
Invest in legal advice from a lawyer who’s expertise is technology investment so you can be guided on structuring terms and determining the mechanism (i.e. priced round or convertible note) for an investment round that suits your venture’s strategy and stage of growth. If you’re investment ready and looking for a legal expert to support an capital raising, I recommend you contact Daniel Szekely. He and his team provide outstanding service to AirShr. And remember, receiving signed term sheets from prospective investors is an incredible milestone but it only takes you 60% of the way to closing the round. Your lawyer should guide you through the balance of this process.
10. No investor is going to sign an NDA before receiving your pitch deck. Be OK with that.
The reality is that your pitch deck does not (and should not) contain intellectual property. Send it to prospective investors ahead of a scheduled meeting in the spirit of advancing their knowledge and ability to make an informed response to your request for investment.
And by the way, the likelihood of a prospective investor replicating / stealing your idea is ridiculously low (at best). If you’re not convinced, speak to Robert Kawalsky at Zeetings and use their awesome product to distribute and solicit feedback on your pitch deck.
11. Prepare for your valuation to be challenged
It’s important for the founding team to set a preliminary valuation for their company. For technology ventures, arriving at a valuation using a discounted cashflow model, particularly when pre-revenue, isn’t helpful. the DCF model will be flawed due to its fictitious assumptions and the inherent lack of cash flow.
Instead, consider the ‘stages method’ of valuation. This is a commonly used and surprisingly accurate approach to determining valuation of early stage technology companies and is based on their development. Once the valuation is established, determine a range within which the founding team will accept investment. As you introduce this valuation to prospective investors prepare for it to be challenged. This is part of negotiating a deal and at this point it comes down to convincing prospective investors that the valuation is reasonable.
Next post: How should I approach raising capital?
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